Why The Bear Market Could Be Over In A Flash

08/04/2016 12:23 pm ETUpdated
Aug 05, 2017

Oil entered bear market territory this week as WTI and Brent fell more than 20 percent from their June peaks. WTI even dropped below $40 per barrel for the first time in three months and oil traders have become incredibly pessimistic about the trajectory of oil prices, settling in for another summer swoon.

But several prominent voices believe that the bear market could be over in a flash. Notable oil trader Andy Hall says that there could be a "violent reversal" in the near future for oil prices. And analysts from Citigroup, Bank of America Merrill Lynch, BNP Paribas and Wood Mackenzie also see a turnaround coming.

Of course, there is no guarantee that oil analysts have it right, but the options market also reflects confidence in a near-term rebound. The premium paid for protection against further losses in oil prices has plunged, reflecting little worry among oil traders that there is more room on the downside for WTI and Brent. Bloomberg reports that the "put skew" for December Brent and WTI options has declined by 30 percent since June.

"This is telling us that they see little chance of us hitting $25 in the near term," John Kilduff, partner at Again Capital LLC, told Bloomberg.

Andy Hall, who runs the hedge fund Astenbeck Capital Management LLC, said that a rebound is imminent. "The market is being driven by its own momentum and currently that is down," Hall wrote in a note to his investors. "But extreme positioning coupled with improving fundamentals should ultimately - and at potentially any time - result in a strong reversal."

The near-term fundamentals do not exactly inspire confidence in a strong rally. Gasoline demand has been strong but could wane as the summer ends. Refining maintenance could lessen demand for crude oil - demand from refiners often drops by 1.2 million barrels per day between July and October. High inventories will take a long time to drawdown. Meanwhile, OPEC is producing at record levels and large volumes of fresh supply could come back in Nigeria and Libya. Nevertheless, supply and demand continue to move towards balance. The global supply surplus is shrinking, and demand continues to rise while global oil production could fall.

"We view this dip as a buying opportunity. We're still looking for oil to be back in the $50-plus range heading into the year-end," Francisco Blanch, head of commodity markets strategy at Bank of America Merrill Lynch, said on Bloomberg TV.

Skip York, VP of integrated energy at Wood Mackenzie says that oil hits a "structural bottom" at the low-$40s. "There isn't enough oil that is active in the $40s," York said on Bloomberg TV. "The market just can't stay there. We saw that in January and February." So even if prices dip into the $30s, they will have to bounce back again as supply goes offline.

Wood Mackenzie predicts that because there is not enough oil that is profitable at today's prices, there could be a shortage somewhere down the road. The painful cutbacks in spending across the oil industry will sow the seeds of the next price spike. Skip York says that today's oil bears are wrong to think that oil production will bounce back quickly when oil prices rise a bit. "It seems like a lot of the financials just think that you can just flip a light switch and crude comes back...you gotta move rigs into the field and you gotta hire people to run those rigs." He concedes that the short-cycle nature of shale drilling could mean that shale comes back relatively quickly, but notes that such a scenario is unknown - this will be the first time that the shale industry will be tested coming out of a price crash.

Moreover, although some rigs started to come back once oil prices rebounded to the $40s from the lows seen earlier this year, York says there is not enough profitable shale in the $40s to halt the decline in overall U.S. oil production; even if shale companies can quickly resume drilling, new production will only slow the rate of decline. And besides, even in the unlikely scenario that all of the potential U.S. oil production did in fact come back online, "there is not enough oil in the U.S. to switch over the decline on a global basis," York said.